EU Reform Will Batter Your Bank Shares

If adopted, these banking reforms will surely slash long-term returns for shareholders.

LONDON -- Since the U.K.'s twin bubbles in credit and housing burst in 2008, British banks have gone from being value creators to value destroyers on a vast scale. Even worse, proposed new restrictions on future bank behavior warn shareholders to brace themselves for lower long-term returns.

Blown-up banksAs it "circled the drain" in late 2008, the balance sheet of Royal Bank of Scotland(LSE: RBS.L) was grossly swollen to 2.4 trillion pounds, or over 1.5 times U.K. GDP (gross domestic product, or national output). At the same time, the bank's free capital was diving perilously close to zero, while its leverage stood at 42 times its equity base at the end of 2007.

However, as a bank deemed "too big to fail," RBS was brought back from the brink by massive, taxpayer-backed cash injections totaling 45.2 billion pounds. To date, RBS's plunging share price has created a paper loss for taxpayers approaching half (48%).

Add this 21.6 billion pounds lost on RBS to an additional loss of 7 billion pounds for bailing out Lloyds Banking Group(LSE: LLOY.L), and on paper, these two bailouts have cost British taxpayers a total of 28.6 billion pounds. This comes to almost exactly 1,100 pounds for each of the U.K.'s 26 million households!

Clearly, we cannot afford and must not allow banks to behave so recklessly ever again, hence the ongoing attempts by regulators in the U.K., U.S. and European Union (EU) to bring these giants to heel.

Five big changes for banksIn the aftermath of the bailouts, the Independent Commission on Banking (ICB) was set up to review U.K. banking regulation, chaired by Sir John Vickers. This Vickers report recommended ring-fencing retail banks from banks' investment-banking operations. In similar fashion, the Volcker reforms aim to improve the stability of U.S. banks.

However, the most radical voices for bank reform are coming from Europe and, in particular, from the European Commission-backed Liikanen Group, chaired by Erkki Liikanen, governor of Finland's central bank.

Released on Tuesday 2 October, the Liikanen report makes these five key recommendations to prevent future banking crises within Europe (and on the wider global stage):

1. Ring-fenced tradingBanks engaged in significant proprietary trading (trading on their own account) and market-making should separate and assign these activities to a separate legal entity. Hedging services for clients would not need to be ring-fenced.

If a bank's trading positions exceed 100 billion euros, or 15% to 25% of its total assets, then this arm must be detached so that government-insured customer deposits would no longer support "casino trading." This would force trading divisions to raise their own capital, pushing up their funding costs and lowering their profits.

2. Bail-in assetsTo spread the pain of losses more widely among stakeholders, Liikanen recommends that banks build up a substantial layer of "bail-inable debt."

These instruments would also be used to pay bonuses to top management, so that if a bank makes life-threatening losses, then these unsecured bondholders would be wiped out before taxpayers step in. Again, this would push up banks' long-term funding costs, thus reducing future profits and dividends.

3. Prudent risk managementLiikanen also proposes that banks are more consistent in their treatment of risk in internal models, to produce balances risk weightings across the board. With particular emphasis on the treatment of property lending, this is aimed at improving the calculation of minimum capital standards.

Under Liikanen, banks would no longer be able to gorge on highly-rated instruments that later turn into toxic debt, as did bonds and derivatives linked to U.S. subprime mortgages. Again, by forcing banks to set aside more capital against riskier loans, this would make banks safer, but at the expense of future shareholder returns.

4. Better boardroomsLiikanen also wants better corporate governance from banks, so as to stamp out excessive "rewards for failure." This would involve beefing up boardrooms and top management with experienced bankers, an elevated role for risk management and disclosure, reduced compensation for leaders, plus greater monitoring of (and sanctions against) reckless banks.

In effect, this would reduce risk-taking by bank bosses, while favoring long-term returns over short-term trading.

5. Preserving critical functionsIn addition, Liikanen is hot on disaster management, requiring banks to create "living wills" to enable insolvent banks to be wound up in an orderly fashion. Again, this extra level of security to shield savers would come at a cost to shareholder returns.

Could do better?While bankers have reacted with predictable dismay at the structural reforms set out in the Liikanen report, reforms could go further still. While this set of safeguards would do much to protect savers from future market storms, they are by no means a guarantee of future good behavior by banks.

For example, when U.S. investment bank Lehman Brothers collapsed into bankruptcy in mid-September 2008, it had a core capital buffer above 11%. Hence, even a relatively high level of liquid, quality assets is no absolute guarantee of survival during market mayhem.

Personally, I strongly believe that bank leverage must be capped, so as to reduce the risk of their free capital being wiped out during slumps. Never again should banks be able to gear up their balance sheets to 40 or 50 times their equity. Indeed, a sensible leverage limit of, say, 15 to 20 times would help return banks to their reliable roots.

Banks: Bargains or value traps?For at least two years, I've closely watched bank stocks in a hunt for emerging value. Even though banks have bolstered their balance sheets and liquidity, I have yet to plunge back into their shares.

This is just as well, as bank shares have been pitiful performers since October 2010. Over the past 24 months, RBS shares have plunged 45%, and Lloyds has crashed more than 48%. Barclays(LSE: BARC.L) has dived 24%, and HSBC(LSE: HSBA.L) has fared much better, down less than 9%. Over this period, the FTSE 100 index of blue-chip shares is up almost 5%, so banks have performed terribly by comparison.

After adjusting for risk, the bank showing the most obvious value is HSBC, thanks to its generous dividend of 4.7%, covered a healthy 2.1 times.

Then again, U.K. domestic property is still very overpriced, thus leaving plenty of room for the risky loans of the Noughties to go bad later this decade. With potential for another "write-down cliff" of legacy property assets in the face of rising interest rates, it's hard to be bullish on British banks right now!

Lastly, star fund manager Neil Woodford sold out of U.K. banks long before the crash. Thanks to a market-beating performance that is second to none, Woodford now manages 20 billion pounds for U.K. investors. To find out which great businesses he owns, read "Eight Shares Britain's Super-Investor Loves."